Monday, September 11, 2017

It is difficult to understand how companies get away with presenting fictitious earnings that result from their preferred accounting measures (which, as far as I can see, are basically whatever the firm wants its numbers to be). Needless to say, the resulting earnings differ significantly from those that would be produced using GAAP principles. While firms also have to report those GAAP numbers, they are allowed to bury them and highlight their non-GAAP numbers, instead. As the article in the url below notes, this happened recently with PayPal's second-quarter financial results, which were published at the end of July:

"Revenues grew to $3.14 billion in the quarter that ended in June, an increase of 18 percent over the same period last year. Total payment volume of $106 billion was up 23 percent, year over year. Even better, PayPal's favored earnings-per-share measure — which it does not calculate in accordance with generally accepted accounting principles, or GAAP — came in at 46 cents per share, 3 cents more than Wall Street analysts had expected. The company has trained investors to focus on this number, rather than on the less pretty GAAP-compliant numbers most companies are judged by."

The main concern of the article is the amount of compensation paid as stock options, which (for some hard-to-explain reason) PayPal excludes as a cost:

"How could stock-based compensation — which is a company expense, after all — have helped PayPal's performance in the quarter? Simple. The company does not consider stock awards a cost when calculating its favored earnings measure. So when PayPal doles out more stock compensation than it has done historically, all else being equal, its chosen non-GAAP income growth looks better."

How much better, exactly?

"Under generally accepted accounting principles, PayPal reported operating income of $430 million in the second quarter of 2017. That was up almost 16 percent from the $371 million it produced in the same period last year. But under PayPal's alternative accounting, its non-GAAP operating income was $659 million in the June quarter, an increase of almost 25 percent from 2016. So what's to account for the added $230 million in operating income under PayPal's preferred calculation? Most of it — $192 million — was stock-based compensation PayPal dispensed to employees in the June quarter and added back to its results as calculated under GAAP."

How is it that investors are quite happy to accept this? It clearly presents a distorted view of the firm's performance. Perhaps it is just that people see what they want to see and some firms are favored by investors, for whatever reason:

"PayPal's stock has been on a tear this year, up almost 50 percent since January. At a recent $59, its shares are trading at over 40 times next year's earnings estimates. It is clearly an investor darling, providing all the more reason to dig into its numbers."

You might not be surprised to know that there are other stakeholders in PayPal who also stand to benefit from the practice:

"The company says it has three main metrics for calculating its managers' performance pay each year. One of those measures, its proxy shows, is non-GAAP net income. So, as PayPal awards more and more stock to its executives and employees, non-GAAP net income shows better growth. And the greater that growth, the more incentive pay the company awards to its top executives."